# 5.1.1: Environmental Economics


Environmental and natural resource economists study the tradeoffs associated with one of the most important scarce resources we have—nature. Economists mean something very specific when they use the word efficient. In general, an allocation is efficient if it maximizes social well-being, or welfare. Traditional economics defines welfare as total net benefits—the difference between the total benefits all people in society get from market goods and services and the total costs of producing those things. Environmental economists enhance the definition of welfare. The values of environmental goods like wildlife count on the “benefit” side of net benefits and damages to environmental quality from production and consumptive processes count as costs.

Under ideal circumstances, market outcomes are efficient. In perfect markets for regular goods, goods are produced at the point where the cost to society of producing the last unit, the marginal cost, is just equal to the amount a consumer is willing to pay for that last unit, the marginal benefit, which means that the net benefits in the market are maximized. Regular goods are supplied by industry such that supply is equivalent to the marginal production costs to the firms, and they are demanded by consumers in such a way that we can read the marginal benefit to consumers off the demand curve; when the market equilibrates at a price that causes quantity demanded to equal quantity supplied at that price, it is also true that marginal benefit equals marginal cost.

Even non-renewable resources such as oil would be used efficiently by a well-functioning market. It is socially efficient to use a non-renewable resource over time such that the price rises at the same rate as the rate of interest. Increasing scarcity pushes the price up, which stimulates efforts to use less of the resource and to invest in research to make “backstop” alternatives more cost-effective. Eventually, the cost of the resource rises to the point where the backstop technology is competitive, and the market switches from the non-renewable resource to the backstop. We see this with copper; high prices of non-renewable copper trigger substitution to other materials, like fiber optics for telephone cables and plastics for pipes. We would surely see the same thing happen with fossil fuels; if prices are allowed to rise with scarcity, firms have more incentives to engage in research that lowers the cost of backstop technologies like solar and wind power, and we will eventually just switch. Unfortunately, many conditions can lead to market failure such that the market outcome does not maximize social welfare. The extent to which net benefits fall short of their potential is called deadweight loss. Deadweight loss can exist when not enough of a good is produced, or too much of a good is produced, or production is not done in the most cost-effective (least expensive) way possible, where costs include environmental damages. Some types of market failures (and thus deadweight loss) are extremely common in environmental settings.

## Externalities

In a market economy, people and companies make choices to balance the costs and benefits that accrue to them. These side effects can be seen as ways in which the actions of a producer impact the well being of a bystander. The market fails to allocate adequate resources to address such side effects because it is only concerned with buyers and sellers, not with the well-being of the environment. When this is true economists say there are externalities, and individual actions do not typically yield efficient outcomes. A negative externality is a cost associated with an action that is not borne by the person who chooses to take that action.

When external costs occur, a company’s private production cost and the social cost of production are at odds. The firm does not consider the cost of pollution cleanup to be relevant, while society does. The social costs of production include the negative effects of pollution and the cost of treatment. As a result, the social costs end up exceeding the private production costs. When external pollution and treatment costs are included in the production cost of the product, the supply curve intersects the demand curve at a higher price point. As a result of the higher price there will be less demand for the product and less pollution produced.

For example, exhaust pollutants from automobiles adversely affect the health and welfare of the human population. However, oil companies consider their cost of producing gasoline to include only their exploration and production costs. Therefore, any measures to reduce exhaust pollutants represent an external cost. The government tries to help reduce the problem of exhaust pollutants by setting emissions and fuel-efficiency standards for automobiles. It also collects a gasoline tax that increases the final price of gasoline, which may encourage people to drive less. Sometimes, pollution results from the production process because no property rights are involved. For example, if a paper manufacturer dumps waste in a privately owned pond, the landowner generally takes legal action against the paper firm, claiming compensation for a specific loss in property value caused by the industrial pollution. In contrast, the air and most waterways are not owned by individuals or businesses, but instead are considered to be public goods. Because no property rights are involved the generation of pollution does not affect supply and demand.

Firms have an incentive to use public goods in the production process because doing so does not cost anything. If the paper manufacturer can minimize production costs by dumping wastes for free into the local river then it will do so. The consequences of this pollution include adverse impacts on the fish and animal populations that depend on the water, degradation of the surrounding environment, decrease in the quality of water used in recreation and business, human health problems and the need for extensive treatment of drinking water by downstream communities. An important role of the government is to protect public goods, especially those with multiple uses, from pollution by companies seeking to minimize company costs and to maximize profits. People desire clean water for recreation and drinking, and the government must act to protect the broad interests of society from the narrow profit-driven focus of companies.

Other example of negative externalities in environmental settings include:

• Companies that spill oil into the ocean do not bear the full costs of the resulting harm to the marine environment, which include everything from degraded commercial fisheries to reduced endangered sea turtle populations).
• Commuters generate emissions of air pollution, which lowers the ambient quality of the air in areas they pass through and causes health problems for other people.
• Developers who build houses in bucolic exurban settings cause habitat fragmentation and biodiversity loss, inflicting a cost on the public at large.

A positive externality is a benefit associated with an action that is not borne by the person who chooses to take that action. Positive externalities exist in the world of actions and products that affect the environment including:

• A homeowner who installs a rain barrel to collect unchlorinated rainwater for her garden also improves stream habitat in her watershed by reducing stormwater runoff.
• A delivery company that re-optimizes its routing system to cut fuel costs also improves local air quality by cutting its vehicle air pollution emissions.
• A farmer who plants winter cover crops to increase the productivity of his soil will also improve water quality in local streams by reducing erosion.

## Public Goods and Common-Pool Resources

Market outcomes are almost never efficient in two broad kinds of cases: public goods and common-pool resources. The market failures in these settings are related to the problems we saw with externalities. A pure public good is defined as being nonexclusive and nonrival in consumption. If something is nonexclusive, people cannot be prevented from enjoying its benefits. A private house is exclusive because doors, windows, and an alarm system can be used to keep nonowners out. A lighthouse, on the other hand, is non-exclusive because ships at sea cannot be prevented from seeing its light. A good that is nonrival in consumption has a marginal benefit that does not decline with the number of people who consume it. A sandwich is completely rival in consumption: if I eat it, you cannot. On the other hand, the beauty of a fireworks display is completely unaffected by the number of people who look at it. Some elements of the environment are pure public goods: Clean air in a city provides health benefits to everyone, and people cannot be prevented from breathing.

The efficient amount of a public good is still where social marginal benefit equals the marginal cost of provision. However, the social marginal benefit of one unit of a public good is often very large because many people in society can benefit from that unit simultaneously. One lighthouse prevents all the ships in an area from running aground in a storm. In contrast, the social marginal benefit of a sandwich is just the marginal benefit gained by the one person who gets to eat it. Society could figure out the efficient amount of a public good to provide—say, how much to spend on cleaner cars that reduce air pollution in a city. Unfortunately, private individuals acting on their own are unlikely to provide the efficient amount of the public good because of the free rider problem. If my neighbors reduce pollution by buying clean electric cars or commuting via train, I can benefit from that cleaner air; thus, I might try to avoid doing anything costly myself in hopes that everyone else will clean the air for me. Evidence suggests that people do not behave entirely like free riders – they contribute voluntarily to environmental groups and public radio stations. However, the levels of public-good provision generated by a free market are lower than would be efficient. The ozone layer is too thin; the air is too dirty. Public goods have big multilateral positive externality problems.

In contrast, a common-pool resource (also sometimes called an open-access resource) suffers from big multilateral negative externality problems. This situation is sometimes called the “tragedy of the commons.” Like public goods, common-pool resources are non-excludable. However, they are highly rival in use. Many natural resources have common-pool features: Water in a river can be removed by anyone near it for irrigation, drinking, or industrial use; the more water one set of users removes, the less water there is available for others. Swordfish in the ocean can be caught by anyone with the right boat and gear, and the more fish are caught by one fleet of boats, the fewer remain for other fishers to catch. Old growth timber in a developing country can be cut down by many people, and slow re-growth means that the more timber one person cuts the less there is available for others. One person’s use of a common-pool resource has negative effects on all the other users. Thus, these resources are prone to overexploitation. One person in Indonesia might want to try to harvest tropical hardwood timber slowly and sustainably, but the trees they forebear from cutting today might be cut down by someone else tomorrow. The difficulty of managing common-pool resources is evident around the world in rapid rates of tropical deforestation, dangerous over-harvesting of fisheries, and battles fought over mighty rivers that have been reduced to dirty trickles. The tragedy of the commons occurs most often when the value of the resource is great, the number of users is large, and the users do not have social ties to one another, but common-pool resources are not always abused.

## Incentive Policies

Incentive policies try to make use of market forces for what they do best—allocating resources cost-effectively within an economy—while correcting the market failures associated with externalities, public goods, and common pool resources.

### Taxing Pollution

One way to "internalize" some of the external costs of pollution is for the government to tax pollution. A pollution tax would require that polluting firms pay a tax based on the air, water and land pollution that they generate. This tax would raise the private production cost of a company to include to the social cost of production. In addition, the generated tax revenues could be used by the government to help mitigate the effects of pollution. Thus, if we think the social cost of ton of carbon dioxide (because of its contribution to climate change) is $20, then we could charge a tax of$20 per ton of carbon dioxide emitted. The easiest way to do this would be to have a tax on fossil fuels according to the amount of carbon dioxide that will be emitted when they are burned.

If a price is placed on carbon dioxide, all agents would have an incentive to reduce their carbon dioxide emissions to the point where the cost to them of reducing one more unit (their marginal abatement cost) is equal to the per unit tax. Therefore, several good things happen. All carbon dioxide sources are abating to the same marginal abatement cost, so the total abatement is accomplished in the most cost-effective way possible. Furthermore, total emissions in the economy overall will go down to the socially efficient level. Firms and individuals have very broad incentives to change things to reduce carbon dioxide emissions—reduce output and consumption, increase energy efficiency, switch to low carbon fuels—and strong incentives to figure out how to innovate so those changes are less costly. Finally, the government could use the revenue it collects from the tax to correct any inequities in the distribution of the program's cost among people in the economy or to reduce other taxes on things like income.

While taxes on externality-generating activities have many good features, they also have several drawbacks and limitations. First, while an externality tax can yield the efficient outcome (where costs and benefits are balanced for the economy as a whole), that only happens if policy makers know enough about the value of the externality to set the tax at the right level. If the tax is too low, we will have too much of the harmful activity; if the tax is too high, the activity will be excessively suppressed. Second, even if we are able to design a perfect externality tax in theory, such a policy can be difficult to enforce. The enforcement agency needs to be able to measure the total quantity of the thing being taxed. In some cases that is easy—in the case of carbon dioxide for example, the particular fixed link between carbon dioxide emissions and quantities of fossil fuels burned means that through the easy task of measuring fossil fuel consumption we can measure the vast majority of carbon dioxide emissions. However, many externality-causing activities or materials are difficult to measure in total. Nitrogen pollution flows into streams as a result of fertilizer applications on suburban lawns, but it is impossible actually to measure the total flow of nitrogen from a single lawn over the course of a year so that one could tax the homeowner for that flow. Third, externality taxes face strong political opposition from companies and individuals who don't want to pay the tax. Even if the government uses the tax revenues to do good things or to reduce other tax rates, the group that disproportionately pays the tax has an incentive to lobby heavily against such a policy. This phenomenon is at least partly responsible for the fact that there are no examples of pollution taxes in the U.S. Instead, U.S. policy makers have implemented mirror-image subsidy policies, giving subsidies for activities that reduce negative externalities rather than taxing activities that cause those externalities.

## Discounting and Cost Benefit Analysis

Economists have developed a tool for comparing net benefits at different points in time called discounting. Discounting converts a quantity of money received at some point in the future into a quantity that can be directly compared to money received today, controlling for the time preference. A particular cost or benefit is worth less in present value terms the farther into the future it accrues and the higher the value of the discount rate. These fundamental features of discounting create controversy over the use of discounting because they make projects to deal with long-term environmental problems seem unappealing. The most pressing example of such controversy swirls around analysis of climate-change policy. Climate-change mitigation policies typically incur immediate economic costs (e.g. switching from fossil fuels to more expensive forms of energy) to prevent environmental damages from climate change several decades in the future. Discounting lowers the present value of the future improved environment while leaving the present value of current costs largely unchanged. Cost-benefit analysis is just that: analysis of the costs and benefits of a proposed policy or project. To carry out a cost-benefit analysis, one carefully specifies the change to be evaluated, measures the costs and benefits of that change for all years that will be affected by the change, finds the totals of the presented discounted values of those costs and benefits, and compares them. Some studies look at the difference between the benefits and the costs (the net present value), while others look at the ratio of benefits to costs. A “good” project is one with a net present value greater than zero and a benefit/cost ratio greater than one. The result of a cost-benefit analysis depends on a large number of choices and assumptions. What discount rate is assumed? What is the status quo counterfactual against which the policy is evaluated? How are the physical effects of the policy being modeled? Which costs and benefits are included in the analysis—are non-use benefits left out? Good cost-benefit analyses should make all their assumptions clear and transparent.

Cost-benefit analysis gives us a rough sense of whether or not a project is a good idea. However, it has many limitations. Here we discuss several other measures of whether a project is desirable. Economists use all these criteria and more when evaluating whether a policy is the right approach for solving a problem with externalities, public goods, and common-pool resources.

Efficiency

A policy is efficient if it maximizes the net benefits society could get from an action of that kind. Such efficiency will occur when the marginal benefits of the policy are equal to its marginal costs. Sometimes a cost-benefit analysis will try to estimate the total costs and benefits for several policies with different degrees of stringency to try to see if one is better than the others. However, only information about the marginal benefit and marginal cost curves will ensure that the analyst has found the efficient policy. Unfortunately, such information is often very hard to find or estimate.

Cost Effectiveness

It can be particularly difficult to estimate the benefits of environmental policy, and benefit estimates are necessary for finding efficient policies. Sometimes policy goals are just set through political processes—reducing sulfur dioxide emissions by 10 million tons below 1980 levels in the Clean Air Act acid rain provisions, cutting carbon dioxide emissions by 5% from 1990 levels in the Kyoto protocol—without being able to know whether those targets are efficient. However, we can still evaluate whether a policy will be cost effective and achieve its goal in the least expensive way possible. For example, for total pollution reduction to be distributed cost-effectively between all the sources that contribute pollution to an area (e.g. a lake or an urban airshed), it must be true that each of the sources is cleaning up such that they all face the same marginal costs of further abatement. If one source had a high marginal cost and another’s marginal cost was very low, total cost could be reduced by switching some of the cleanup from the first source to the second.

Incentives to Innovate

At any one point in time, the cost of pollution control or resource recovery depends on the current state of technology and knowledge. For example, the cost of reducing carbon dioxide emissions from fossil fuels depends in part on how expensive solar and wind power are, and the cost of wetland restoration depends on how quickly ecologists are able to get new wetland plants to be established. Everyone in society benefits if those technologies improve and the marginal cost of any given level of environmental stewardship declines. Thus, economists think a lot about which kinds of policies do the best job of giving people incentives to develop cheaper ways to clean and steward the environment.

Fairness

A project can have very high aggregate net benefits, but distribute the costs and benefits very unevenly within society. We may have both ethical and practical reasons not to want a policy that is highly unfair. Some people have strong moral or philosophical preferences for policies that are equitable. In addition, if the costs of a policy are borne disproportionately by a single group of people or firms, that group is likely to fight against it in the political process. Simple cost-benefit analyses do not speak to issues of equity. However, it is common for policy analyses to break total costs and benefits down among subgroups to see if uneven patterns exist in their distribution. Studies can break down policy effects by income category to see if a policy helps or hurts people disproportionately depending on whether they are wealthy or poor. Other analyses carry out regional analyses of policy effects. For example, climate-change mitigation policy increases costs disproportionately for poor households because of patterns in energy consumption across income groups. Furthermore, the benefits and costs of such policy are not uniform across space in the U.S. The benefits of reducing the severity of climate change will accrue largely to those areas that would be hurt most by global warming (coastal states hit by sea level rise and more hurricanes, Western states hit by severe water shortages) while the costs will fall most heavily on regions of the country with economies dependent on sales of oil and coal.

Some of our evaluative criteria are closely related to each other; a policy cannot be efficient if it is not cost-effective. However, other criteria have nothing to do with each other; a policy can be efficient but not equitable, and vice versa. Cost-benefit analyses provide crude litmus tests—we surely do not want to adopt policies that have costs exceeding their benefits. However, good policy development and evaluation considers a broader array of criteria.

## Gross National Product and Its Alternatives

Most countries strive to increase their capacities to produce goods and services and consider doing so as a positive sign of development. Economic growth is stimulated by population growth, which in turn increases the consumption of natural resources and increases the per capita consumption of goods and services. Various indicators are used to measure economic growth. One of them is the Gross National Product (GNP), which represents the total market value of final goods and services produced by a country during a given period (usually one year). Unfortunately, GNP does not take into account the global nature of many companies. If a company produces goods in a foreign country, then the "home" country does not really benefit from that production. Thus, if Pepsi bottles and sells soda in Japan, those revenues should not be included in the GNP of the United States. The GDP (Gross Domestic Product) provides a better indicator of the health of a country’s economy. This measure refers to the value of the goods and services produced within the boundaries of an economy during a given period of time.

Both the GNP and Gross Domestic Product (GDP) are economic measures and indicate nothing about social or environmental conditions within a country. They are not measures of the quality of life. In fact, severe environmental problems can actually raise the GNP and GDP, because the funds used to clean up environmental contamination (such as hazardous waste sites) help to create new jobs and increase the consumption of natural resources. Alternative systems to GDP have been suggested that are based on genuine wellbeing and progress. The UN Human Development Index is an estimate of the quality of life in a country based on three indicators: life expectancy, literacy rate and per capita GNP. The Genuine Progress Index (GPI) is based on measurements that include health care, safety, clean environment, pollution and crime. The Environmental Performance Index (EPI) is based on indicators tracked in two categories: protection of human health from environmental harm and protection of ecosystems.